Chapter II Fundamental causes of consolidation

Transcription

1 Chapter II Fundamental causes of consolidation 1. Introduction This chapter is concerned with the fundamental causes of consolidation. 33 To this end, it reviews and builds upon the extensive body of literature academic scholars and other researchers have produced in this field. As generalisations about the main forces driving consolidation are sometimes affected by country-specific circumstances, interviews have been conducted with 45 selected industry participants and experts from the G1 countries, Australia and Spain. These individuals have been asked for their opinions on the basis of a common interview guide, which covers the issues of each section of the chapter. The analysis distinguishes between motives for consolidation and the environmental s that influence the form and pace of consolidation. In practice, motives and environmental s are intertwined, but for the purposes of this chapter it has proven useful to treat them separately. The environmental s are divided into two categories: those that encourage consolidation and those that discourage consolidation. The remainder of the chapter is structured as follows. Section 2 analyses the motives for consolidation in the financial sector and examines the main empirical studies. Section 3 deals with the environmental s encouraging consolidation, which include technological change, deregulation, globalisation, the institutionalisation of savings, and the introduction of the euro. Section 4 discusses the s that may discourage or impede financial sector consolidation, such as regulations and differences in culture and corporate governance. Section 5 examines three possible future scenarios, based mainly on the outcomes of the interviews. Annex II.1 contains country synopses based on the interviews, where the country-specific causes of consolidation are described. Annex II.2 provides technical information on the structure of the interviews. 2. Framework Theory Mergers and acquisitions in the financial sector are undertaken for a wide variety of reasons. In any given case, more than one motive may underlie the decision to merge. Motives may vary with firm characteristics such as size or organisational structure, over time, across countries, across industry segments, or even across lines of business within a segment. In the framework used in this chapter, the motives for mergers and acquisitions are broken down into two basic categories: value-maximising motives and non-value-maximising motives. In a world characterised by perfect capital markets, all activities of financial institutions would be motivated by a desire to maximise shareholder value. In the real world, while value 33 In this chapter, mergers and acquisitions and consolidation are considered as synonyms. The various forms of consolidation are described in more detail in Chapter I. 65

2 maximisation is an underlying most decisions, other considerations can, and often do, come into play. Value-maximising motives The value of a financial institution, like any other firm, is determined by the present discounted value of expected future profits. Mergers can increase expected future profits either by reducing expected costs or by increasing expected revenues. Mergers can lead to reductions in costs for several reasons, including: economies of scale (reductions in per-unit cost due to increased scale of operations); economies of scope (reductions in per-unit cost due to synergies involved in producing multiple products within the same firm); replacement of inefficient managers with more efficient managers or management techniques; reduction of risk due to geographic or product diversification; reduction of tax obligations; increased monopsony power allowing firms to purchase inputs at lower prices; allowing a firm to become large enough to gain access to capital markets or to receive a credit rating; providing a way for financial firms to enter new geographic or product markets at a lower cost than that associated with de novo entry. Mergers can lead to increased revenues for a variety of reasons, including: increased size allowing firms to better serve large customers; increased product diversification allowing firms to offer customers one-stop shopping for a variety of different products; increased product or geographic diversification expanding the pool of potential customers; increased size or market share making it easier to attract customers (visibility or reputation effects); increased monopoly power allowing firms to raise prices; increased size allowing firms to increase the riskiness of their portfolios. Non-value-maximising motives Managers actions and decisions are not always consistent with the maximisation of firm value. In particular, when the identities of owners and managers differ and capital markets are less than perfect, managers may take actions that further their own personal goals and are not in the interests of the firm s owners. For example, managers may derive satisfaction from controlling a larger organisation or from increasing their own job security. Thus, they might engage in mergers designed to increase the size of the firm or reduce firm risk, even if such mergers do not enhance firm value. Managers may acquire other firms in order to avoid being acquired themselves (defensive acquisitions), even if being acquired would benefit the firm s owners. In some cases, managers may care about the size of their firm relative to competitors, leading them to engage in consolidation simply because other firms in the industry are doing so. 66

3 The role of government Government policy can play an role in either facilitating or hindering consolidation. Governments sometimes facilitate consolidation in an effort to minimise the social costs associated with firm failures. In the United States, for example, government agencies provided financial assistance to healthy banks that acquired failing banks during the banking crises of the 198s and early 199s. Financial crises or major problems with large depository institutions also contributed to accelerated changes in the banking landscape in France, Japan, Scandinavia and the United Kingdom. In resolving failed institutions, supervisory authorities have often encouraged mergers or forced the liquidation and sale of the weakest institutions. For example, in Japan during the banking crisis of the 199s, government funds were deployed to support reconstruction and consolidation of the banking sector. Governments may also promote consolidation in an effort to create a national champion that can compete effectively in the global arena. At the same time, laws requiring regulatory approval of mergers and acquisitions or prohibiting certain types of mergers and acquisitions (because of their implications for competition, financial stability, potential conflicts of interest between commercial and investment banking, or other reasons) have the potential to hinder consolidation. Empirical evidence on the motives for consolidation Numerous empirical studies have attempted to determine the motives for mergers, both within the financial services sector and more broadly. 34 Unfortunately, the actual motives for mergers are not directly observable and may differ from those stated by management at the time of a merger announcement. Researchers are limited to inferring the motives from observable s such as the relationship between average cost and firm size, the characteristics of firms that merge, the effects of mergers on stock prices, and the post-merger performance of cost and price measures. Economies of scale and economies of scope Many researchers have estimated the relationship between average cost and firm size or product scope for the banking industry, in an attempt to determine the importance of economies of scale and economies of scope in banking. Studies of economies of scale and economies of scope in financial services sectors other than commercial banking are less numerous. Overall, these studies seem to support the view that economies of scale may be a motivating for mergers involving small or medium-sized financial services firms, particularly during the 199s. They do not provide support for the view that economies of scale are an driving mergers involving the very largest firms in the industry. It should be noted, however, that for very large diversified firms, economies of scale may be more difficult to detect because they may be limited to certain product lines and not show up in aggregate, firm-level data. Thus far, there seems to be little or no evidence in support of the importance of economies of scope as a motivator. Cost efficiency In some cases, managers do not operate a firm in a manner that minimises the cost of producing given quantities and combinations of products. In this case, the firm is said to suffer from cost inefficiency. Consolidation can help to eliminate cost inefficiency if the acquiring firm s management is more effective at minimising costs than the target s management, and is able to eliminate unnecessary costs after the combination takes place. Studies of the characteristics of the firms involved in financial sector mergers and acquisitions generally support the view that efficiency gains motivate consolidation. These studies tend to find that acquiring firms are more 34 See Chapter V for a review of this literature. 67

4 cost efficient than target firms. However, studies that examine ex post changes in cost efficiency resulting from mergers and acquisitions generally fail to find any evidence that efficiency gains are realised. The consistent failure of research to document efficiency gains from mergers may reflect accounting complexities that make it very difficult to measure changes in cost efficiency or unanticipated difficulties in achieving post-merger efficiency gains. Nonetheless, these studies cast some doubt on the significance of efficiency gains as a motivating. Monopoly power Mergers and acquisitions can sometimes enhance monopoly power, allowing firms to increase profits by setting prices that are less favourable to customers. This is particularly true when the merging firms are direct competitors and their combination results in a substantial increase in market concentration. Few studies have directly examined the effects of financial sector mergers and acquisitions on prices. Although the findings of these studies are somewhat mixed, those that focus on the types of mergers that are most likely to increase market power do find evidence of significant price effects. Numerous studies have examined the effects of bank mergers on profitability. Some have found increased profitability associated with mergers and acquisitions, while others have not. However, increased profitability does not necessarily imply increased monopoly power, since efficiency gains or cost savings owing to scale or scope economies could also yield improvements in profitability ratios. Although the evidence is sparse, it seems likely that when direct competitors merge, especially when they already operate in a fairly concentrated market environment, increased monopoly power is one of the s motivating the consolidation. Non-value-maximising motives As indicated above, when capital markets are imperfect and there is separation of ownership from management, managers may undertake consolidations (or other activities) that are not in the interest of the acquiring firm s owners. A number of mechanisms exist to reduce the probability of managers engaging in activities that are contrary to the interests of the firm s owners. These include: Managerial stock ownership. If managers own a substantial amount of stock in the firms they run, they are likely to have a personal interest in maximising firm value. Concentrated shareholder ownership. If shareholder ownership is highly concentrated, shareholders are likely to do a better job of monitoring managerial behaviour than if shareholder ownership is widely dispersed. Presence of independent outsiders on the board of directors. Likewise, monitoring of managerial behaviour is likely to be easier or more effective if there are independent outsiders on the firm s board of directors. Numerous studies of non-financial firms and a few studies of commercial banks have examined the extent to which these mechanisms reduce the probability of managers entering into nonvalue-maximising mergers. 35 Although the studies do find evidence that these mechanisms are somewhat effective, their findings provide support for the view that at least some mergers are undertaken for reasons other than value maximisation. Evidence from the interviews In the interviews with financial sector participants and industry experts, a number of questions were asked about the motives for consolidation, distinguishing within-country from cross- 35 See, for example, Allen and Cebenoyan (1991) and Subrahmanyam, Rangan and Rothstein (1997). 68

5 border combinations, and within-segment from across-segment combinations. (Responses to questions about the motives for consolidation are summarised in Chart II.1.) Several interviewees indicated that motives differed across industry segments (eg commercial banking versus investment banking versus insurance) and across product lines (notably between wholesale and retail services), as well as with firm size. However, the number of interviews is not large enough to allow meaningful distinctions to be drawn along these various dimensions in analysing the responses. With respect to within-country, within-segment mergers, the single strongest motivating appears to be the desire to achieve economies of scale. Thirty-six out of 45 respondents indicated that economies of scale were very in motivating this type of consolidation (see Chart II.1, panel 1a). This finding contrasts rather sharply with the findings of the academic literature (particularly on the US financial sector), which suggest fairly limited economies of scale in financial services. One should bear in mind, though, that this finding may be less paradoxical than it seems because the econometric studies are backward looking, making it difficult to achieve reliable estimates of scale economies that can explain the current industry consolidation. Several interviewees explained, for example, that the large investments required to take advantage of the latest technological advances or to develop innovative products could only be undertaken by very large organisations. Others noted that mergers provide an opportunity to reduce staffing and eliminate branches, thereby reducing costs. Other motivating s for within-country, within-segment mergers, according to the interviewees, were revenue enhancement due to increased size and increased market power (see Chart II.1, panels 3a and 7a). Note that most interviewees interpreted market power to mean market share, rather than the ability to influence price. The argument presented was that a larger market share makes a firm more visible and therefore more attractive to potential customers. In Europe, a larger market share may also be a defensive motive to become one of the major players in the pan-european market. It was also mentioned that larger banks are better positioned to support large bond issues because they have access to a larger capital base, command a more extensive network to place these issues in the market, and have the advantage of name recognition. Risk reduction due to product diversification and change in organisational focus were considered largely irrelevant for this type of consolidation (see Chart II.1, panels 5a and 6a), while economies of scope, revenue enhancement due to product diversification, and managerial empire building and entrenchment were considered to be slightly (see Chart II.1, panels 2a, 4a and 8a). For within-country, across-segment mergers, the most motive appears to be revenue enhancement due to product diversification, or the ability to offer customers one-stop shopping (see Chart II.1, panel 5b). Forty-five per cent of the respondents cited this motive as being very, 7% ranked it somewhere between moderately and very, and 27% judged it to be moderately. The desire to achieve economies of scope was perceived by interviewees to be the second most motive for this type of merger, with 25% of the respondents ranking it as very and 3% classifying it as moderately (see Chart II.1, panel 2b). Economies of scale, revenue enhancement due to increased size, risk reduction due to product diversification, change in organisation focus, market power, and managerial empire building and entrenchment were all considered to be slightly s (see Chart II.1, panels 1b, 3b, 5b, 6b, 7b and 8b). Many respondents did not provide rankings for the motives for cross-border mergers due to the fairly limited amount of cross-border consolidation that has taken place to date. The responses that were provided to these questions suggest that the strongest motives for within-segment cross-border consolidation were increased market power and revenue enhancement due to both increased size and increased product diversification. With regard to cross-segment, cross-border consolidation, revenue enhancement was also considered to be a strong motivator, but increased market power was viewed as only slightly. 69

6 3. Forces encouraging consolidation Introduction This section is concerned with the external forces that have encouraged consolidation in the financial services industry. In some jurisdictions (eg Japan in the 199s), consolidation has been driven largely by the need to recapitalise distressed institutions after a major crisis. More generally, much of the ongoing restructuring in financial services has been a strategic response on the part of market participants to changes in the competitive environment. Among the major forces creating pressure for change are: technological advances; deregulation; and globalisation of the marketplace. Just as the motives underlying mergers and acquisitions vary with firm characteristics, etc, the key external forces also appear to vary across multiple dimensions in their influence. In some cases, the basic structural forces are the same, but the impact differs because of different starting points with respect to the number of firms and the range of activities conducted within a given firm. Comments received in the interviews suggest that cross-border mergers are more likely for institutions located in countries that have already experienced considerable domestic consolidation, where the scope for further consolidation based on an exclusively domestic focus has either diminished or bumped up against policy limitations. Various respondents suggested, as well, that different categories of institutions might react to different s. For example, the need to absorb excess capacity may encourage consolidation among smaller institutions to a greater extent than among larger institutions. Unfortunately, as noted previously, the small number of observations does not permit meaningful distinctions to be drawn along these lines. Evidence from the interviews does suggest that the influence of the external s has been supported in some cases by changes in investor saving patterns and the introduction of the euro, which have served as catalysts for mergers among institutions in some jurisdictions. In addition, surging stock prices (for acquirers) and low interest rates have provided a supportive environment in which to finance transactions. In sum, technology, deregulation and globalisation have eased or removed entry barriers and paved the way for increased competitive pressures. Shareholders, meanwhile, have become more active. Corporate governance practices still vary across jurisdictions, but the shareholder value concept has gained adherents. Thus, as increased competition has squeezed profit margins for many financial institutions, managers have been forced to seek measures to improve performance, including ways to reduce costs, increase revenues, or employ resources more effectively. There are a number of strategic alternatives to achieve these goals, including: organic growth; de novo entry (especially in niche areas); distribution and other strategic alliances; and mergers and acquisitions. All of these strategies have been implemented to varying degrees in most jurisdictions, but mergers and acquisitions have clearly been a big element of the strategic response to date. Going forward, however, the opportunities for online delivery of financial products and services may lead to less emphasis on mergers and acquisitions to achieve entry and increased use of cooperative agreements such as production partnerships, joint ventures and distribution alliances. This will be further discussed in Section 5 on future trends. 7

7 Technological changes Technology has both direct and indirect effects on the restructuring of financial services. Direct effects of technology may include: increases in the feasible scale of production of certain products and services (eg credit cards and asset management); scale advantages in the production of risk management instruments such as derivative contracts and other off-balance sheet guarantees; and economies of scale in the provision of services such as custody, cash management, back office operations and research. Many wholesale services, in particular, have high technology investment costs but low margins, given customers demands for increasingly sophisticated services at lower prices. Providers of these services often pursue mergers and acquisitions as a means of spreading the high set-up costs of new technological infrastructure over a larger customer base. The same may be true of providers of retail products like credit cards. A large firm size helps to counterbalance competitive pressures and provides the wherewithal for the continuous technology upgrades necessary to achieve any unit-cost advantage in pricing services that are basically commodity products. Large size may also provide diversification benefits. Dramatic improvements in the speed and quality of telecommunications, computers and information services have helped to lower information and other costs of transacting (see Table II.1). This development has had a dramatic impact on the financial services industry. A few key examples are: Changes in distribution capacity. As a result of increased speed and lower costs of computing and telecommunications equipment, financial service providers can, with the appropriate technology infrastructure, offer a broader array of products and services to larger numbers of clients over wider geographic areas than would have been feasible in the past. This process has facilitated the move towards increasingly global connections among financial markets and made a global reach feasible for service providers. Creation of new financial services and products. Technological advances combined with innovations in financial engineering techniques have enabled service providers to unbundle and repackage the risks embedded in existing financial products to tailor new products to meet the risk management and investment needs of specific customers. Modern technology enables financial institutions to make rapid adjustments in the characteristics of their investment portfolios, including the risk profile, and facilitates the efforts of non-financial corporations to develop global operations by providing for the separation of exchange rate fluctuations and other financial risks from their normal business operations. Blurring of distinctions. Technology in conjunction with deregulation of product offerings results in competition on a product-by-product basis. Financial institutions of all types now offer products and services that not only compete against those offered by intra-sector competitors, but also against those offered by other categories of service providers. Banks are increasingly engaging in non-traditional activities and securities firms and non-banking institutions have made inroads in traditional banking activities. The same technologies have enabled non-financial entrants to provide a range of banking-type products. In the process, many financial products have been converted into commodities, characterised by a high degree of standardisation and competition focused on price. Data mining. Technological advances have also enabled financial service providers to harness information more productively, which means that differentiated or specially tailored products can be created and channelled to targeted customers. Technology 71

8 supports the implementation of strategies based on the marketing and mass distribution of commodity-like products. A prime example is the use of direct mail or telemarketing campaigns to offer standardised loan products to retail or small business customers that have a certain risk profile, based on assessments from a credit-scoring model. New entrants. At the retail level, electronic delivery channels such as the internet and automated lending technology enable service providers to take advantage of their brand names and customer databases to reach out to targeted customers, without the need for a pre-existing physical presence. Although some physical presence in the market will probably remain a necessary element in the provision of retail banking services, these technologies potentially remove one of the main entry barriers to the retail financial services business. Online delivery channels make it possible for out-ofmarket institutions to compete for retail (and also small business) customers as well. Moreover, sophisticated search engines enable customers to comparison-shop more easily, so differences in prices are readily exposed and competitors have a relatively low-cost channel through which a competing firm s customers can be reached. How entry by out-of-market institutions might affect concentration in a financial industry is not clear-cut. This would in part depend on the form entry would take (eg de novo entry, mergers and acquisitions, cooperative agreements such as strategic alliances). Furthermore, new entry might stimulate a change in the structure of the industry. For a more comprehensive discussion, see Section 5 on future trends. In short, technological advances have changed the competitive functioning of the financial sector, at both the production and the distribution level, and have created incentives for new output efficiencies. As noted in the section on motives, such a restructuring process provides many opportunities for mergers and acquisitions. In the interviews, technological advances were considered to be an force encouraging consolidation, especially with respect to within-country, within-segment combinations. Over 6% of respondents indicated that improvements in information and communications technology were very in encouraging this type of merger, while another 2% said they were moderately (see Chart II.2, panel 1a). Fifty-eight per cent of respondents ranked financial innovation as a moderately or very force encouraging within-country, within-segment consolidation (see Chart II.2, panel 2a). More than half of the interview respondents viewed each of these technology-related forces as at least moderately in encouraging domestic, cross-segment consolidation and cross-border, within-segment consolidation (see Chart II.2, panels 1b, 2b, 1c and 2c). Electronic commerce was viewed as a less force with regard to encouraging all types of consolidation (see Chart II.2, panel 3). Deregulation Governments influence the restructuring process in a number of ways: through effects on market competition and entry conditions (eg placing limits on or prohibiting cross-border mergers or mergers between banks and other types of service providers); through approval/disapproval decisions for individual merger transactions; through limits on the range of permissible activities for service providers; through public ownership of institutions; and through efforts to minimise the social costs of failures. Over the past two decades, many official barriers to consolidation have been relaxed as governments have reconsidered the legal and regulatory framework in which financial institutions operate. (See Annex II.3 for a chronological listing of regulatory changes.) In a number of countries, regulations in the financial services industry, especially as 72

9 applied to banking organisations, tended in the past to focus almost entirely on safety (eg consumer protection and prevention of failures). However, financial regulatory frameworks in most major countries have shifted from systems based on strict regulatory control to systems based more on enhancing efficiency through competition, with an emphasis on market discipline, supervision and risk-based capital guidelines. In the new operating environment, public policy is less protective of financial service providers (banks), exposing them to the same sorts of market pressures that have long confronted non-financial businesses. Mergers and acquisitions have been a major component of the restructuring process. This process owes in part to deregulation, but it is difficult to disentangle the effects of regulatory reform in financial services from the effects of advances in technology, innovations in financial engineering and other developments that work in the same direction and may have preceded the changes in regulation. Deregulation in the financial service industry has often been an induced response by policymakers to technological advances and financial crises. At times, regulatory changes have merely ratified changes that had been previously implemented by the market. For example, there is some evidence that technological innovations in deposit taking and lending encouraged deregulation in that area, and technological advances were also a enabling financial institutions in the United States to overcome functional and geographic limitations that had been designed into their charters. 36 The fact that consolidation in some cases has preceded changes in legislation suggests perhaps that deregulation may not be a strictly necessary in the textbook sense. The main influence of deregulation appears to be that it enlarges the set of legal tactical manoeuvres, including the types of agreements that can be arranged across sectors and across borders, and thereby gives institutions increased flexibility to respond to competitive impulses. In the interviews, over half of the respondents indicated that deregulation was at least moderately as a encouraging consolidation for domestic, within-segment institutions, with over one third of the respondents ranking it as a very (see Chart II.2, panel 4a). Thirty-eight of the respondents assigned a ranking to this for domestic, cross-segment consolidation. As before, about half of the respondents said this was at least moderately in encouraging consolidation (see Chart II.2, panel 4b). A similar frequency breakdown occurs in the case of cross-border consolidation, but the total number of respondents is smaller (Chart II.2, panels 4c and 4d). Globalisation Globalisation is in many respects a by-product of technology and deregulation. Technological advances have lowered computing costs and telecommunications, while at the same time greatly expanding capacity, making a global reach economically more feasible. Deregulation, meanwhile, has opened up many new markets, both in developed and in transition economies. As a encouraging consolidation, globalisation largely affects institutions providing wholesale services. Comments received during the interviews indicate that global corporations expect financial service providers to have the necessary expertise and product mix to meet any investment or risk management need in any location in which the corporations have operations. 37 As non-financial corporations increased the geographic scope of their operations, they created a demand for intermediaries to provide products and services attuned to the international nature of their operations. Maintaining a presence in multiple financial markets and offering a breadth of products and services can entail relatively high fixed costs, creating a See Kane (1999). This is one of the basic tenets of client-based universal banking - the service provider chooses the appropriate products, services and geographical presence to service its client base. For a more complete discussion, see Calomiris and Karceski (1998). 73

10 need for large size to achieve scale economies. Nonetheless, interviewees did not rate the globalisation of the non-financial sector as an force encouraging financial consolidation (see Chart II.2, panel 5). Meanwhile, profit margins in many wholesale business segments have narrowed as a result of increased ease of entry and the commodity-like nature of many wholesale financial products. Low margins, in effect, mean that high volumes are necessary to generate higher returns. This need has prompted some firms to opt for mergers and acquisitions as a means of attaining critical mass. Mergers and acquisitions have also been a frequent option for banks seeking to build a global retail system. By acquiring an existing institution in the target market, the acquirer gains a more rapid foothold than would be possible with an organic growth strategy (see Box II.1). In addition to increasing the need for wholesale service providers to expand the scale of their operations, globalisation has helped change the competitive dynamics of other market segments. Many financial products are now offered internationally by efficient global competitors, through direct or targeted distribution channels. Some traditional retail banking products and services are still provided on a regional or local level, but a few global providers (eg Spanish banks in Latin America) have begun to make competitive inroads in many markets. National and regional players are forced to respond to the threat posed by new entrants either by emulating their product offerings (which results in commoditisation), or by offering better pricing, which requires increased efficiency, or by offering better services (eg through customisation or personal service). The globalisation of capital markets also contributes to the shift from a bank-centred system to a market-based one. As capital markets have expanded and become more liquid and efficient, the highest-quality credits have turned increasingly to the commercial paper and bond markets in lieu of certain types of traditional bank and insurance products. Margins on loans to the highestrated investment grade borrowers have been driven down to the point that only the most efficient institutions are able to provide this form of credit. On the liabilities side of banks balance sheets, there has been a substantial outflow of deposits to a wide range of competing financial products offered by various institutions in different sectors. For insurers, mutual funds and related products compete against guaranteed investment contracts. In response to the increased competitive pressures, some institutions have opted to expand via the merger route to reach a perceived threshold size for scale economies (see Chart II.2, panel 6a). A final influence of globalisation is in the area of corporate governance. As businesses have crossed international boundaries and their shares have begun to be held by a wider investor clientele, the demand by investors for a more uniform standard of corporate governance has also increased. Generally, the pressure for change has come from shareholders located outside the home market. A major contributing is the ongoing change in investor demographics. 74

11 Box II.1 Spanish banks strategy in Latin America Acquisitions of large shareholdings in the Latin American financial sector by Spanish institutions are an interesting example of cross-border consolidation. This expansion by the largest Spanish banks was initially focused mainly on emulating the Spanish model of retail banking, but lately has also included the acquisition of private pension funds. The main countries that have been involved in the region are Argentina, Brazil, Chile, Colombia, Mexico, Peru and Venezuela. A number of s have supported these efforts. Most governments in the targeted countries have taken steps to modernise their economies and, in particular, reform their banking and financial systems through deregulation, restructuring and privatisation, while opening their domestic markets to foreign institutions. Other supporting s include: the importance of the common language, historical ties and other cultural s; the strong financial solvency position of the acquiring banks, coupled with the need to implement strategies that increase shareholder value; higher potential growth in these countries compared with the EU owing to a faster rate of population increase; higher intermediation margins in Latin American banking systems compared with those of more developed countries (compensating for the reduction in margins that has taken place in Spain due to fierce competition in retail banking and the reduction in interest rates); the adaptability of readily available products and delivery systems; minimal correlation between the economic cycles of Latin America and Spain, which allows some risk diversification. Although there are high risks associated with these investments, given financial sector instability in the region, the belief is that the immediate introduction of the parents management processes, systems and improved risk management will enhance profitability quickly. This expansion has resulted in strong franchises, which may prove to be a powerful advantage in coping with expected future consolidation in the European financial sector. Shareholder pressures Differences in corporate governance standards still exist among major countries, but use of the shareholder value concept has become more widespread and with it has come a focus on the return on assets and the return on equity (ROE) as benchmarks for performance. This emphasis on ROE is most evident in countries where capital markets exert strong competitive pressures, but its importance is spreading rapidly. One development that has helped to boost the importance of shareholders relative to other stakeholders is the increased institutionalisation of savings stemming from ageing populations in most countries. 38 Financial assets are increasingly being held by large well-informed investors, who base their investment decisions on relative asset returns. Importantly, it has become more common for a large share of the funds institutional investors have under management to be placed with professional fund managers, who develop asset allocation strategies and make investment decisions on behalf of their institutional investor clients. Fund managers actively compete for the opportunity to manage funds from pension plans, foundations, life insurance companies, and so on. Renewal of management contracts and the fund manager s compensation typically have been based on the fund manager s relative investment performance. Consequently, professional fund managers have strong incentives to 38 In many countries, ageing and the need for retirement income has prompted growth of private pension plans as alternatives to state-sponsored, pay-as-you-go systems. See, for example, OECD (1998). 75

12 express their dissatisfaction with low rates of ROE. This increased activism translates into pressure on managers of financial institutions to generate higher levels of profitability. In response, managers have sought ways to increase revenues, create new sources of earnings, generate fee income, reduce cost-to-income ratios, optimally deploy excess capital or, for some institutions, recapitalise after a major crisis. These goals can be achieved through business gains, productivity enhancement or more effective balance sheet management, but mergers and acquisitions appear to be a simpler strategy for many institutions. In the interviews, the institutionalisation of savings was considered to be a moderately to very encouraging consolidation by 5 to 6% of respondents for each type of consolidation considered (see Chart II.2, panel 7). The introduction of the euro Another development that has had an impact on the competitive environment for some institutions is the creation of the euro. The general view of the euro is that it acts as a catalyst, reinforcing already existing trends in EU banking systems. However, the surge in consolidation activity in the euro area just prior to and after the euro s launch leads to some speculation that the euro might have independent effects. 39 Assessing the specific impact of the euro on financial sector consolidation is, however, rather complex for two reasons. First, by the time the euro was introduced, the European financial sector had already undergone several changes dating back to the end of the 198s, basically as a result of the harmonisation efforts in the context of the single market and the environmental s outlined in the previous section, supported by a general trend towards liberalisation of capital movements. Second, the relationship between the euro and the consolidation process varies by segment of the financial system (money and capital markets versus retail markets). Financial markets Since its inception, the euro has quickly led to an integrated money market, thereby affecting the motives for consolidation in two ways. First, the euro has removed the pricing advantage in the home interest rate previously enjoyed by domestic banks specialised in dealing in the relevant currency. This change may have put pressure on the profitability of some domestic banks that were large in their domestic system but have a much smaller share of the new integrated money market. Second, given the size of the integrated money market, there is a need for providers of payment services to smaller banks, which favours larger institutions because the required technological equipment entails huge installation costs. For these service providers, the degree of revenue enhancement would be even greater if a synergy were to develop between money market and capital market activities, thus enabling them to provide a wide array of interconnected financial services to other financial institutions. The euro also affects the treasury activities of the corporate sector in the euro area. Internationally operating corporations used to maintain a correspondent banking connection in several European countries, but under the single currency these relations have been reduced significantly. This development may have encouraged consolidation among banks, because in order to serve these international corporate clients, particularly the larger ones, size may have become more relevant. 39 According to data obtained from Securities Data Corporation and presented in Chapter I, the value of merger and acquisition transactions involving target firms located in the nine European countries included in our study reached USD 147 billion in 1999, compared with USD 13 billion in 1998 and USD 88 billion in In 1999, several cross-border mergers took place in the euro area. This process continued in 2 (eg HSBC-Crédit Commercial de France, MeritaNordbanken-UniDanmark). 76

13 The euro also contributes to more integrated capital markets, although this process proceeds with a lower intensity than in the money market. In general, the integration of capital markets has three main effects on the motives for bank consolidation: it creates the potential for revenue enhancement due to increased size, particularly in the case of institutional investment; there is the potential for economies of scale on the cost side; and sufficient size may be required to take full advantage of risk diversification within an industry throughout the euro area. The integration of capital markets represents an opportunity for institutional investors to extend their activity since the size and liquidity of the markets have grown. It may be argued that only large banks are able to develop knowledge throughout the euro area, together with the pool of human resources and the technological capacity needed to suit the needs of large institutional investors, especially in the fields of underwriting, securitisation, investment banking and asset management. Asset allocation in the euro area is increasingly carried out on an industry basis rather than on a country-by-country basis. Accordingly, analysts are being required to follow a larger number of companies, which may entail economies of scale. Integration has also proceeded in the government bond markets. A high degree of liquidity is ensured for benchmark bonds, whose yield to maturity is nearly uniform across the euro area. Spreads between government bond yields and interbank rates have decreased also as a consequence of the restructuring of primary markets carried out by several European governments at the end of the 199s (eg through the introduction of new competitive auction procedures). This process has penalised particularly those banks that depended on the yield on their government bond portfolio for a significant share of their income. The resultant pressure on margins could induce these banks to pursue cost savings or ways to enhance income, which could lead to merger activity. In the interviews, roughly 45% of the respondents said the euro was not a influencing domestic consolidation and approximately 4% said it was not a encouraging crossborder consolidation. At the same time, approximately 3% of respondents indicated that the euro was a very encouraging within-segment mergers, both domestic and cross-border (see Chart II.2, panel 8). Respondents views of the importance of the euro varied with their locations. Interviewees from euro area countries tended to rank this much higher than those outside the euro area did. Numerous respondents indicated that the euro was likely to become a more significant force in the future than it has been to date. 4. Forces discouraging consolidation Introduction There are many other external s that affect the way financial institutions respond to the changes in their operating environment. This section pays attention to those s that discourage consolidation, such as regulatory regimes, information failures, cultural differences, structures in corporate governance and various other s. As with the forces encouraging consolidation, the relative importance of the s addressed may differ across segments and countries. In addition, some s discourage certain types of consolidation. In particular, hostile takeovers are impeded much more than friendly mergers, which largely explains the lack of hostile takeovers in the banking industry. For example, government regulation can make 77

14 permitted hostile takeovers within commercial banking more expensive and time consuming than in non-bank sectors. 4 Also, ownership structures and corporate governance structures (eg the protection of minority shareholder rights) can make it very difficult to acquire a bank through a hostile takeover. Furthermore, as information asymmetries with respect to, for example, the assessment of the loan book of a bank can be substantial, it may be very risky for the bidder to perform an acquisition without the cooperation of the target s management and shareholders. Finally, several interviewees indicated that the lack of hostile takeovers in the banking sector might also be related to the expectations of the bidders that takeover panels and supervisory bodies are likely to turn down this form of corporate control. Bearing these points in mind, the following paragraphs describe the discouraging s in a more general context. Regulation The legal and regulatory environment represents a substantial potential impediment for consolidation, as it affects directly the range of permissible activities undertaken by financial firms and may imply considerable compliance costs. In some countries antitrust laws constitute an impediment, mainly for domestic consolidation within sectors. Prudential regulation may hinder cross-border consolidation through differences in capital requirements. Product-based supervision, which exists largely in the insurance sector, may reduce crossborder consolidation by limiting potential cost reduction from economies of scale. Potential regulatory impediments to consolidation include: Protection of national champions. In some countries, the government has an explicit role in approving foreign investment in domestic financial institutions. Governments may protect domestic enterprises by setting high hurdles for foreign buyers attempting to acquire majority stakes. Conditions in some countries have enabled some categories of banks to remain insulated from market forces. Government ownership of financial institutions. The scope for consolidation is similarly limited when banks are partially or fully government owned. For these institutions, the consolidation of business activities with others would have to be preceded by privatisation. Competition policies. Competition policies are concerned with the negative welfare effects stemming from a lack of competition. Some consolidation projects are refused on the grounds that they would result in market dominance. A further deterrent related to competition policy rules is the fact that some mergers have to pass the test of competition authorities in different countries, which involves long delays, compliance costs and uncertainty. Rules on confidentiality. National regulations with regard to data provision and confidentiality may prevent the consolidation of information platforms on a crossborder and an across-segment basis and, thereby, impede potential cost reductions from technologically induced economies of scale. Nearly 6% of interviewees viewed legal and regulatory constraints as a very impediment to cross-border mergers, and an additional 15 to 2% viewed them as moderately. Respondents considered legal and regulatory constraints to be somewhat less in discouraging domestic consolidation; nonetheless, more than 6% of them rated these s as at least moderately (see Chart II.3, panel 1). It should be noted that, over time, regulatory differences across countries can be expected diminish, tending to reduce barriers to cross-border consolidation. 4 See Prowse (1997). 78

15 Cultural differences Cultural differences appear in the consolidation process on the corporate level, between sectors, across regions or countries and between wholesale and retail businesses. The need for cultural integration as part of the consolidation process is a multidimensional issue that touches all stakeholders. Cultural differences increase the complexity, and therefore the costs, of managing size. Post-merger problems have often been ascribed to the underestimation of the difficulties involved in attempts to combine different cultures. Differences between countries. The importance of cultural differences is especially obvious when a merger crosses national borders or spans geographically distinct regions. Factors that may discourage consolidation include differences in language, communication styles, customer needs and specific established distribution channels. These s determine the ease, and thus the implicit costs, of a firm s entry into a different country or region. Differences in corporate cultures. Strong corporate identities are considered to be particularly problematic in mergers between equals. Takeover attempts often turn unfriendly when there are large perceived rifts in business cultures between the acquirer and the target. Such differences may impede the exchange of information, the pursuit of common objectives and the development of a coherent corporate identity. Divergent corporate cultures may exist between corporations within the same business segment, as well as across business lines (eg commercial and investment banking activities that may compete with different products for the same customer base). Not surprisingly, interviewees indicated that cultural constraints were most with regard to cross-border consolidation. Approximately two thirds of respondents described cultural constraints as a very discouraging cross-border mergers, whether within or across segments. Cultural constraints were also viewed as an impediment to domestic mergers involving firms in different industry segments by 4% of interviewees. Nearly half of all respondents considered cultural constraints at least moderately in deterring within-segment, within-country mergers (see Chart II.3, panel 2). Inadequate information flows Inadequate information flows are a form of market inefficiency that may increase the uncertainty about the outcome of a merger or acquisition. They may be attributed to incomplete disclosure or large differences in accounting standards across countries and sectors. 41 When faced with such an information asymmetry, stakeholders may disapprove of consolidation. Lack of comparability of accounting reports. Large variations in accounting principles and procedures from country to country or even across sectors can impede consolidation, as there may be considerable uncertainty regarding the risk profile and valuation of the assets of the institutions involved in the transactions. The growing complexity of large transactions in recent years has further increased the importance of reliable and transparent accounting standards in order to conduct adequate due diligence procedures in mergers and acquisitions. Difficulties in asset appraisal. The existence of information asymmetries is a commonly acknowledged complication in appraising assets particularly in the context of bank s loan books, which include assets for which market liquidity is low. An 41 Due to developments in information technology and the subsequently more widespread implementation of international accounting standards such as the International Accounting Standards and the US Generally Accepted Accounting Principles, the spread and quality of financial information available in G1 countries in recent years have improved. 79

16 assessment of the loan book of an institution implies the difficult task of judging the quality of risk management of the takeover target, which is especially problematic in the context of evaluating single loans. Lack of transparency. Ex ante pressure from shareholders to justify a merger decision may be a discouraging in the presence of uncertainty and information asymmetries. The potential for hidden costs, as a result of a lack of transparency, may induce acquiring management and shareholders to be more risk averse when considering an acquisition. Most interviewees did not view market inefficiencies as a particularly inhibiting consolidation, except in the case of cross-border, within-segment mergers (see Chart II.3, panel 3). Corporate governance Corporate governance encompasses the organisational structure and the system of checks and balances of an institution. There are significant differences in the legislative and regulatory frameworks across countries as regards the functions of the ( supervisory ) board of directors and senior management, which affect the interrelation of the two decision-making bodies within an institution and relations with the firm s owners and other stakeholders, including employees, customers, the community, rating agencies and governments. Ownership structures. The organisational form and rules that govern the strategic business decisions of a company have a large bearing on whether consolidation is deemed a valid business option. For example, a strong corporate identity can be an effective defence against surrendering control to outsiders. The mutual form of ownership is a special type of ownership structure that may impede consolidation. In some countries mutuals have a large market share in the life insurance and mortgage businesses as well as among depository institutions. Capital structure. Corporate governance should not be viewed independently from corporate finance. As the way of raising capital varies, so do the possibilities for influencing or pressuring the supervisory board with regard to decisions on consolidation. Such influence appears to be greatest for firms that rely heavily on equity financing and whose shares are widely held. Where there are a few large shareholders, it is extremely difficult to sway the vote of the governing board without their express approval. Banks that have lent extensively to an enterprise may exercise similar de facto corporate control, although they may not be represented on the supervisory board. Existence of defensive strategies. Defences against a takeover are strongest where financing is from private sources and the major share of equities is privately held. Defensive strategies are manifold and include payoff provisions for managers, ie golden parachutes, or legal and technical obstacles such as complex ownership agreements ( poison pills ) or cross-shareholdings with other institutions. Though not listed separately in the structured interview guide (see Annex II.2), a number of interviewees emphasised that differences in corporate governance may discourage consolidation. Other discouraging s The process of consolidation is a complex phenomenon and includes judgements about interrelationships among many s. Two other s that may discourage firms from going forward with a merger or acquisition that were mentioned in the interviews are the costs associated with managing complex institutions and taxation: 8

17 Costs of complexity. An reason for unsuccessful consolidation is likely to be the underestimation of the costs or the complexity of managing large and heterogeneous institutions and the difficulties of unifying different corporate cultures. For example, a strategy of combining businesses with highly volatile earnings such as investment banking with more stable performers such as life insurance or private banking might lead to a loss in focus as well as undermine the specific strengths of the constituents. Taxation. Assessing the impact of the various tax regimes on investment decisions is a complex issue. The tax burden is a cost that is ed into business decisions. As such, it influences the choice of location for the different parts of a business. Although consolidation could also result in a reduction of tax obligations, enterprises often feel in practice that the direct and indirect costs imposed by taxation do not justify a merger, be it with a domestic partner or a foreign one. For example, high capital gains taxes on the sale of corporate holdings may impede the disentanglement of crossholdings between banks, insurance and industry and, thus, hamper structural adjustment in the financial and corporate sectors. The absence of double taxation agreements between the two countries where the consolidating entities are headquartered would also be an impediment to takeovers. From an efficiency point of view, organisational structures that are optimal from a taxation perspective may be less so from the point of view of production and distribution processes. 5. Future trends Introduction The interview results suggest strongly that the consolidation process in the future will vary from country to country and from segment to segment, depending on different starting points regarding the number of firms and the range of activities conducted within a given firm. The pace of consolidation could accelerate in Europe, given that the encouraging impact of the euro has not yet run its course, while impediments may be reduced as convergence progresses in areas such as regulation and taxation. There is the possibility that a tiered structure might develop in the interbank market in the euro area, whereby a few large banks act as money centre banks. Under these circumstances, the physical location of banks becomes less and the necessary size could be achieved through domestic consolidation. In retail markets, once physical distribution of the euro currency occurs, there is likely to be greater mobility of depositors and borrowers, which is expected to affect competition in the sector on a cross-border basis and reinforce the structural decline in traditional interest margins. The euro favours integration of the retail sector also in an indirect way by exerting pressure on the competent Community and national authorities to remove the residual barriers to cross-border activity. This would lead to a more competitive environment in which the maintenance of excess banking capacity in some European countries is set to become less sustainable. The integration of the corporate bond markets may also affect motives for consolidation, if the issuance of bonds or commercial paper becomes a significant alternative for corporations to traditional bank loans. Interest margins could decrease, inducing banks to pursue cost savings or increased market share through consolidation. It is also noteworthy that, in Europe, concentration in the financial sector is currently much higher in smaller countries such as the Nordic countries and the Netherlands than in the rest of continental Europe, particularly Germany and Italy. Thus, while institutions in the former countries have already engaged in cross-border consolidation, consolidation in the other countries is expected to continue at the national level for a while. In the United States and Japan, where concentration remains low despite recent consolidation, we can expect to see increasing concentration in the financial services sector in the future. 81

18 In all countries, environmental s (eg technology, deregulation and investor demographics) will still influence the pace and form of consolidation. A stock market crash if such were to occur might temporarily slow the pace of financial sector consolidation, but would be unlikely to completely derail it, given the strength of the other underlying forces. The key question, therefore, is not so much whether consolidation will continue in the future, but rather how. In order to explore this issue, the remainder of this section considers a number of alternative future scenarios. It should be noted that these scenarios are not mutually exclusive and could apply simultaneously to different segments of the financial services industry. Scenarios Scenario 1: Universal institutions The first scenario is a continuation of the current trend towards globally active universal service providers that dominate the wholesale business segment along with other service categories. The gaps might be filled in by niche players or regional institutions specialised, for example, in lending to households or to small and medium-sized firms in industries such as agriculture. According to this view of the financial services sector, there would be further consolidation (where legal) between financial and non-financial entities such as internet and communications firms, enabling the financial institutions to secure the advantages of diversification and scale embodied in new technologies. There are, however, reasons to believe that there are upper limits to the advantages of creating ever larger, all-encompassing financial institutions. For example, as the size and complexity of institutions increase, so do the difficulties in managing them. As managerial capacity becomes stretched too far, profits suffer, which often leads to deconstruction or other forms of retrenchment. Scenario 2: Specialised institutions In the second scenario, the deconstruction process is avoided. Consolidation continues apace, but instead of growth in the number of universal banks, firms specialise as they grow. Differences in the optimal scale pertaining to various activities or limited economies of scope also appear to justify at least some degree of product specialisation, for example, in either wholesale or retail activities. Many wholesale institutions already take a global perspective, but in retail segments a regional presence might suffice as the benefits of scale are limited by great differences in the local cultures served. A number of interviewees suggested, moreover, that the optimal size and structure of institutions might depend, in part, on the size of the market in which the institutions operate. In smaller markets such as Scandinavia, medium-sized institutions of a universal nature might be optimal as the benefits of one-stop shopping in such a situation could outweigh any costs of complexity. In large markets such as the United States, specialisation or looser forms of consolidation (eg strategic alliances or joint ventures) may be more appropriate as the costs of merging to become large start to dominate. Scenario 3: Contract banking The third scenario takes the specialisation process in the preceding scenario one step further. In addition to specialisation along functional lines, financial institutions in the future may also choose to specialise in certain production technologies. This would entail a radical departure from current practices, which generally consist of the joint production of a broad line of products and services, including the production of all sub-components (vertical integration). In this respect, a distinction can be made between the manufacture of (components of) financial services and the delivery of these services to the final customer. The key question is whether financial institutions must manage the entire manufacturing process themselves in order to secure scale benefits or whether the same benefits may be realised if (part of) the production process is outsourced. 82

19 In the so-called paradigm of contract banking 42 (which applies equally to other segments of the financial services industry) the answer to the first part of this question is negative. Depending on the comparative advantages of a certain bank, it need manufacture only some of the (components of) services it has on offer, obtaining the rest from other specialised producers (whether in or outside the financial sector proper). Competition would take place on the basis of brand name, the quality of products and services, and pricing. In the extreme case, relying solely on its information advantage, a bank would function as a gateway supplying customers with all the products and advice they need, but doing little more than managing contracts with external suppliers (hence the term contract banking). A good example might be internet banking. Bridges between personal financial software and the websites of financial institutions combined with advances in reliability, security, digital signatures, etc could make it possible for the internet to support a full range of financial services. Third parties may actually originate the various services or advise customers on where to obtain the cheapest offerings. Thus, supply chains could be deconstructed, as different institutions would specialise in certain aspects of the financial intermediation process. Other industries, such as the telecom industry, the automobile sector and the airline industry, are leading the way in this respect. All of these industries have generally disintegrated into a constellation of sub-industries, while the individual firms at the end of the production chain maintain a single marketing channel to the customer. While consolidation among providers of financial services will almost certainly continue in the short-term, it is possible that in the longer run some of this consolidation will be undone. Experience in other economic sectors suggests that merger waves are sometimes (partially) reversed. Usually, though, a merger wave will have inexorably changed the industry, so that the starting point will never be regained. Impact on the consolidation process Although the prospects for the contract banking paradigm may appear somewhat remote for the near future, a few respondents in the interviews indicated that, in some countries, more moderate forms of specialisation in combination with outsourcing are indeed expected to take place ( back to core business ). One policy issue related to this theme is how competition in the financial sector might develop if indeed the future has more specialisation in store, as within certain specialised areas monopoly power might increase. Specialisation to such an extent would certainly change the pattern of consolidation in the financial sector. Consolidation would still occur as firms strove to diversify in terms of both products and markets served, but this process would be accompanied by divestments as the underlying production chain was (partly) broken. At the same time, the various specialised producers, for example in the area of payment processing, might also consolidate. Thus, the structure of the financial sector would become more layered than it is nowadays. Between the extremes of a highly concentrated financial sector consisting of predominantly universal institutions and a more specialised financial sector as described above, there is a whole spectrum of possible outcomes. For example, rather than a complete deconstruction of the production chain, forms of cooperation may be established between the various suppliers, including strategic alliances and joint ventures. In fact, in the interviews a number of financial sector experts suggested that these forms of collaboration might become more common in the future as cross-border and cross-industry cooperation increases, because in those instances more intense forms of consolidation are relatively difficult to realise or justify. What balance will be struck will depend, in particular, on the economies of scope that exist between the various production processes as well as the intensity of competition in the financial sector. The fewer the economies of scope and the higher the level of competition, the greater the pressures 42 The term contract banking derives from Llewellyn (1999). However, similar ideas have been expressed in Deloitte Touche Tohmatsu International (1995) and Evans and Wurster (2). 83

20 towards deconstruction of the production chain will be. In this respect, financial sector regulation may also have a role to play by influencing the degree of financial sector competition from both within and outside the financial services industry. All told, the consolidation trend in the financial sector is likely to continue, given the sustained pressures on the environment in which financial institutions operate. Simultaneously, there are also forces at work that may change the organisation of the financial sector. Of course, exactly how these myriad forces will balance out in the future remains to be seen. 84